2.0 Stock Valuation

Parl l Value
rl sources
CHAPTER
heory is
ides the
r that of
The Value of
:r bond
Common Stocks
flation
>ie 3.6.
rlmart
rat the
)mpa-
o you
r:r,lr:ti:::t::;,.,i .r'::i i
&--
80 Principles of Corporate Finance
EE How courvroru srocxs Rne rRRoeo
shares, as well as individuals who own a handful of shares. tf you owned

one Infosys ,t *", yoo*orta o1n;n
0'000000175041Vo of the comPany and have a claim on the same tinyfraction
of Infosys'profitr.
- t - E - ----' Of course,
the_1o1e shares you oryn, the larger your 'thard, of the company.
Infosys wishes to raise new capital, it can do so either by boirowing or by selling
new shares to investors.
^ ,If
sares ors#e';;;;';;"; lliT'ill'i;?:".:il'#';:ti:;;itr;:,:;:'rT,ii:ffi*ITi:,Ji:'1il;
whgle,illgstgrs-but and sell existing Infosys shares. Stock exchanges
{i:: ?l}:",ock,e,xch},Se,
markets tor secondhand shares, but they prefer to'describe themselves as
are really
secondary markets, which sounds
more important.
The two principal exchanges in India are the National Stock Exchange of India (NSE)
- and the Bom-
lil j*:o Exchange-(BSE). Both compete vigorously for business. T#
handle is immense. For example, on an
that they
day the NSE trades around 706 millio" rh;;l;-r;;:
;";;
"i;;i;;,
150O romneniec "rr"r"g.
longer wishes to hold her shares in the
to increase his stake in the company. The
nee investor to anouter.
ror ro another. No new
new shares *.
rn*L, are
<en place.,I
themselves.
res. Instead their orders must go
her broker a market order to sell
itate a price limit at which he is willing
6 it is recorded in the exchange's limit
Trading Results for lnfosys I

arl
You can track trades in Infosys or other public companies on the Internet. For
example, if you go to tfa(
.Get
moneycontrol.com, enter 'Infosysl and ask to euotes,, you will see results like the table shown on the bot
next page.l
Anr
. Infosys' :l::t$ pt*: on June 7, 2013, was <2,446.g,up 0.87o from the previous day's close. Infosys traded
in aran_geo_f
200
!2,420to?z\zl.go,andbetween tz,tot.es and {3010 overtheprior 52wee}s. Tradingvolume l
was 885,715 shares, well below the three month average of 1,7L4,420 shares
per day. Infosys' markeicap was alx
{ 140,509 crores.
Inv
Infosys' earnings per share (EPS) over the previous 12 months were ( 158.75 ('TTM'
stands for trailing 12 tha
months'). The ratio of stock price to EPS (the P/E ratio) was 15.41. Notice that this p/E
ratio uses past EpS. sim
P/E ratios using forecasted EPS are generallymore useful. Security analysts
forecasted an increase in Infosys, con
EPS to t 168.43 for 20L3-t4,which gives a forward p lE of t4.53.2 fun
Infosys paid a cash dividend of t+z peishare per year, so its dividend yietd(the ratio ofdividend to price) fun
was 1.72o/o.
ma
1*: 9.:O
.:*y of Eading data are moneycentral.msn.com or the online edition of Tle Walt Stre*
Journalat www.wsi.com oook for the *Marke t, md
then "Muket Data' tabs).
2The
websirc www'in'reuters.com 7r*
Provides extensive infomation and statistia on traded compmies, including summaries of analyst forecasts. For example,
you can dick on'Analysts'to get details about the analysts forecasts. direr
The Value of Common Stocks 81
t:: .
t.:
about
:veral million
,u would own
xfv.cllgE opetrHugE acxceew) oF gRffir{€tory,
ts. Of course, argcs a:aoo 0.o(01 a.rsoar}
rooaYtlo{flgr, 2e0,00 w 2lzd0
i to investors. !tt{(Ln.}xH}{ U!i0,S5 ffi 30n9.m
Infosys ta&e
ges are reallv
,hich sounds
rd the Bom-
i{Ax(E?otP{R$c*l 1,t0,509.85 EFgt??till 15S.?5
r that they 1S.{1 E* 13.95 ,
res in some
rBOOi{VALT,EES} 62?35 ?RE€EOO|{ 3"90
tares in th9 o$9r1 I
mpany. The
840.00r,6 aryytElo.{s} 13?s
rr shares are Ii'AH(ETLOT I FiceI,rLHEEg, S.00
rs mpst go
rder to sell
eiiwilting
mge'slimit Sorriaa; ww!,ti.moneyclntrol.com
Buyng stock is a risky occupation. Infosys' stock picked at about <3454 in mid-20i0. By March 2011,
an investor who had bought in at t3,454 would have \ost29o/o of his or her inyestment. Infosys stock
rou go to
traded at 13.36 in 1993 (adjusted for all the bonus issues and stock split). Had some fortunate investor
yn on dre
bought the share at this price, he would have made a whopping 72,724o/o return in the 20 year interval.
Another unfortunate investor would have lost close to about 50% of his investment had he invested in
ys traded
2006 and sold in 2008.
gvolirme
Most of the trading on the BSE and NSE is in ordinary common stocks, but other securities are traded
t cap,was
also, including preferred shares, which we cover in Chaptei 14, and warrants, which we cover in Chapter 21-
Investors can also choose from hundreds of exchange-tradedfunds (ETFs), which are portfolios oistocks
'ailing t2
tast EPS.
tlrat
9an
be bought or sold in a singlg trade. with u-f"* .*."i iorm nrp" *" ;; ";;t ;;;;;J il;
simply aim to track a well-known market index such as Sensex or Nifty. Others track specific iniustries or
Infoqrs'
commodities. (We discuss ETFs more fully in Chapter 14.) You can also buy shares in closed-end mutual
funds3 that invest in portfolios of securities. These include country funds, for exampl., the Mexico and Chile
oprice) funds, that invest in portfolios of stocks in specific countries. Unlike ETFs, most closed-end funds are actively
managed and seek to "beat the market."
hrkef and
rexample, 'Ctosea'e"ai*iifunds lsltie shrestfrai are tmded onkockexchmges. bp en-enilfvrdsm not traded on exchangs. tnvestors in open-end fuirds transaci
directlywith the fund. The fund issues new shares to investors md red6ems shares from investors who want to witidraw th. fr-d"
-ooeyfrom
KS ARE ED 1,
Finding the value of Infosys stock may sound t(
like a simple problem. Each quarter, *" .o*r"rrrliilf
llffi:;.T*.:T*.y:S:*:,:13..j:f
oJ ti", ii.iy"[*ii.;.;,,h.
of Infosvs'assets - plant and machinery
;;#":::fi*r'ff::tj;$i"i#Jr*l
ur,a bank barances,
end orMarch 2013, the bookvarue
Infosys'liabilities - money that it owes ih" b*k
, taxes th3t.are-a,r" to l.
crore' The difference between the value of the fuia, and the like amounted to 16,969
assets and the liabilities was t:o,oss
value of Infosys' equlty. crore. This was the book
Book value is a reassuringly definite number.
Each year, BSR & Cq a member firm of
opinion that Infosys' financial statements present KPMG, gives its
fairly in all *ui.-iJ rop.cts the company's financial
in conformity with India generaily accepted accounting position,
{ principles (commonly known as GAAp). However,
book value of Infosys' assets measures their original (oi"ii.t the
t;
may not be a good guide to what those assets

.i'."t"i .ort r.r, for *
depreciation. This
il
aie worth today. "uowance
ii one can go on and on about the deficiencies of book
value as a measure of market value. Book
ft
ues are historical costs that do not-incorporate val-
inflation. (countries with high or volatile inflation
require inflation-adjusted book values, however.) often
Book valueg"r."uy exdrfie i"r""fiur"
trademarks and patents' Also accountants simply such as
i.Jr"ro., of individualassets,"rsets
aaa up ,rr.
and thus do
,"T:T::ffffi:;1::r':#*?rGoing-conceio,al,'i,.'.",.i'*t'." a couection orassets is organized
Book values can nevertheless be a usefirl benchmark.
If a financial analyst says, ..Infosys sells at 3.9 times
book value"' she is effectively saying that Infosys
has almost qua""n*;
tlBB$rsrrLr its shareholders, past investments
the company. in
Book values may also be usefi'rl clues about tuui!1io1-v1lue.
Liqutdation value is what investors get when
a failed company is shut down and its assets
are sold off. Book values of ..hard,, assets
vehides, and machinery can indicate possible t"rra buildings, tit
liquidation values.
Intangible "soft" assets-can be important even
in liquidation, however Eastman Kodak provides
recent example' Kodah which was one of a good
the Nifty Fifty gr"*th r;;.k* of the 1960s,
,offer.d long
and finally filed for ofYurt* in fanuary 2012. wh;
a decline
was its most valuable asset in bankruptcy?
Its
il#,'r,.o,.:ri,"j|t}r[rtl'j
was.put up ror sale. rhe present value oithe
pat;;;;
.rr,#"a, perhaps
Valuation by Gomparables
when financial analysts need to value a business,
they often start by identifyinga sample of similar firms
as potential
comparables' They then examine how
much investorstin the comparable companies
pared to Pay are pre-
Per rupee of earnings or book assets. They see what the business
the comparables' price-earningJor price-to-book-value would be worth if it traded at
by comparables.
ratios. u"ru"tion approach rii,
is called valuation
Thble 4'1 tries out this valuation method
for-four companies and industries.a Let,s start
unilever (HUt). rn earlv |une 2013, with Hindustan
(EPS) for the year ending March
uur1t".1** ;G-;; fo'ritrrr.por.."riJl*ring, p", ,t*.
2014 is <16.55, giui"g u r?E-*" 35.72. HlllJsmarketrto-book ratio
(price divided by book vJue per share) "r
was p/B aO.+.
=
P/E and P/B for severll
.Hutslompetitors are reported on the right hand side of the table. Note that
HUt's P/E is lower than the 1fP/Es of these comparables. iryo,, aid noi kriow HUlls
stock price, you could get
a
Be extm cuefirl when averaging P/Es' watch
out for companies with,eilnbgs c.lose to rero or negative. one company
inffnite P/E mares my average meaningres. with zerc eamings md tierefore m
often it's
safer ,o *a -.** prr. rather thm averages.
The Value of Common Stocks gg
Stock price' price-eamings (P/E), and market-book (P/B) in June 2013. Selected companies are
compared
lcomparables.
publishes: $tockPnce P/B
Company PlE Comparables P/E P/E
bookvalut lnfosys 2446.5 ,.,15.41. 3.9 23.38
,028 crore., lTcs ,\294
lWipro 14.15 .3.39,
lto t6,g6g Tech 17.78 7'ffi
fHCL
i the book 13.88 3.78
,
lMahindraSatyam
I Average 17.30 6.17
r, gives its I
Hindustan Unilever 36.4 Consumer 57.56

lposition, lGodrei 9.69
: lDabur lndia 46.34 21.03
ryever, the
lcotsate 39.62 ,4.12
fon. This
lpae 52.39 1403, .
I ar*ug, tl8.98
ook val. I
rn often ACC 16.86 3.07 Ultratech Cement 19.17

such as lmori, currnt .J8'0J .ir? .,' .rrigj
-_,-J.,r1
.tii
thus do lShree Cements 15.37
Madras Cements
.}:;,:: i,Eri
ganized 14.12'
Average 16.67 3.62 :: ., ;:1-.i,'
9 times Asian Paints 41.83 14.53 Berger Paints 38:24 7.61

rents in Kansai Nerolac 23.U 5.23
a.-. Shalimar Paints 18.&t 2.ffi
t when t+ Akzo Nobel 24.16 ,
ldings, Average 26.22 4.72
Source,' www. in. moneycontrol.com
r good
ecline an estimate by multiplyingfiUls TTM-EPS by the average P/E for the comparables. The estimatewould be
y? Its somewhat high (at 49.98 x {17.56 = t860.19), but nevertheless usefirl. On the other hand, HULs p/B is much
rhaps than for the comparables. In this case, the wide range of P/Bs for the comparables would give you a
lrUt ".r
hint ular r/l,
unl that P/B rallos
ratios ar€
are treacnerous
treacherous tor this mclustry.
for thrs industry. .
Look now at ACC and the four comparables in Table 4.1. In this case, the P/B ratios are similar for the
comparables, though a little higher for Shree Cements. The average P/E for the comparables for the compa-
irms rables is a little lower (16.67 versus 16.86). Thus valuation by comparables would notnot give you exactly the
pre- right price for ACC, but you would be close.
rd at The ratios for Asian Paints illustrate the difficulties with valuation by comparables. That method would
tion undervalue Asian Paints, because both its P/E and P/B ratios are much higher than the four other paints
companies shown on the right hand side of the table. Investors clearly saw extFa value in Asian paints stock
itan versus its competitors.
are The difficulties in applying the valuation by comparables method for Asian Paints do not invalidate the
rtio :thod. May
method. Maybe
be Table 4.1 doesnt
doesn t shsw
show the best comparables.s A financial manager or analyst would have to dig
deeper to understand Asian Paints' industry the business of manufacturing a wide ra4ge of p4ints fo.r decoral
1at tive and industrial use.
Iet
sOr
maybe the table would work better with different financial ratios. For emmple, malysts may use the ratio of earnings
before interest md taxes (EBIT)
to enterPriie value, defined as the sm ofoutstmd.ing debt md the market cap*"liratio, Lf"q.lty. This ratio is
less sensitive to differences i" a.U, n".".lr,g
policy' In Chapter 19 we discuss valuation when finmcing comes from a mix of debt and equity. Wb discus other
finmcial ratios in Chapter 2g.
Q4 : Prinedple of,.Gqrp-or:ate:F! nance
.,.'9J ; did not need valuation by cory\parables to value Asian Paints or the othel c<
'Eble . public companieg withactively traded shares. Table 4.1 just illustrate; how
stock I
it wai
.1
* p.:.
Suppose Fledgling Electronics stock is selling fort 100 a share (po = 100). Investors expect u tS .uJ airrii,
over the,ne)d year (DIVj=,5)-They'alioellieatthe ,striak to-sell,for'{+I0 a year hence{p-r'= t'tOy. Then
5+110-100
/ : ----------t-]_-- : .15, or 15olo
100
other hand, if you are given investors' forecasts of dividend and price and the expected return (
9" t.
by other equally risky stocks, you can predict todayt price:
Lpanies, DIVr + Pr
Price:Po: t+r.
Electronics DIVI = 5 and P1 = 110. If 4 the expected return for Fledgling is l5%o, then today's
;El be t100:
on. It's a s+110
ntifttlii Pn:
" ?100
1.15
rles'Pl
ixactly is the discount rate, ,; in this calcul-ation? called the market .iPTqir:,irl rate or cost of
just alternative names
-: It's
fgrJle opportunity cost of capital, defined as the expected
'.ly even capital, which are
onother securities with the same risks as Fledgling shares.
:rmines
ye from 'i ''-=tii*y stocks will be safer than Fledgling, and many riskier. But among the thousands of traded stocks
,odel of ',' ,n i. *iU U. a group with essentially the same risks. Call this group Fledgling's risk class. Then all stocks in
, this risk class have to be priced to offer the same
,. -, *^
expected
--*--+^,1 r^+a
rate nf rafrrrn
of return.
.,', '-- Lett suppose that the other securities in Fledgling's risk class all offer the same 15%o expected
'lhen alUU per Snafe
,,,.,,1 return. fnen tfOO
,,:,..,:return.
,:,,,.,:{etufn. Pef share flaShas fOto be
De the right price
LIle TIEIiL Prrce IUIfor rrELr$uuB
Fledgling ILULA. stock. lu In r4!r
fact rL it rD
is the only yvD-
rur vru/ pos-
l, ',:,iiUtr- --:^^
price. \^rLâ if
What if Fledgling's
Elo,l-li--'c price
nrira were rhmre Pq
urcrp above P^ = - ?lnO? In this
{100? thiq case
rese investors
inwestors wouldwottld shift their theif
ng out ,' i::. .sapitat to the other securities and in the process would ---,r r f,----^
force down l^-.,- eL ^
the price
--:^^ of^r El^l-'l:-^
Fledgling stock' ^+^-L r€ If PsD
:Yelar::- I I - -t- r- L---- C^-^.--.L^ .-.. i^
.l ',.*.r. less than 1100, the process would reverse. Investors would rush to buy, forcing the price --l^^ up to
equals I rl, i:100. Therefore at each point in time all securities in an equivalent risk . 1 7
class are priced
- -:--f L^
to offer
-il--- Ll-^
the
. ,'. | qlcn
ill pay " - - -.- t ---L-.--- rL:^ :^
,saqe expected return. This is a condition for equilibrium
^ ^^-l:a:^- f^- ^^,.:'l:L-i,,* i- G'-.+innina
in well-functioning
'.'-lt capital markets. It is also
ranilal marlralc Tt ic
ner of common sense.
rgic of
.,j' ,Next Year,s Price? We have managed to explain todays stockprice Ps in terms of the dividend DIVI and
expected price next year P1. Future stock
rlts r^yee!
. the prices *-
"l--^- r-.--- not easy
are -.:-- -"--ao- to
---t things forecast
-- ---- - t But think about
--- directly.
''g.h+ determines next year's price. If our price formula holds now, it ought to hold then as well:
.
DTV^ + P2
Dtv2 p.
ends.
rd on
Pr: 1*r
,That is, a year from now investors will be looking out at dividends in year 2 and price at the end of year 2. Thus
we can forecast P1 by forecasting DIV2 and P2, and we can express P6 in terms of DIV1, DIY2,andP2:
cash
I 1 l- DIV2+P2\ I:
DIVI+ DIV2+P2
: the
Pn : :-i-(DIVr + Pr) : I DIV' + ---- -
-
(I+r)2
te of r+r r+r\""I'
- l*r ) ttr'
-_-:
per
Take Fledgling Electronics. A plausible explanation for why investors expect its stock price to rise by the end
rtart
of the firsi year is that they expect higher dividends and still more capital gains in the second. Fol example,
suppose that they are looking today for dividends of t5.50 in year 2 and a subsequent price of 1121. That
implies a price at the end of year 1 of
p,:!ir:l%:tlro
'I
1.15
Todays price can then be computed either from our original formula
Dlvl + Pr _ 5.00 +-110 : t100
1*r 1.15
or from. our orpanded formula

DIV, DIV" + P, 5.00_r5.50. +----^ :
' (l+r)2 : :_:_
121
Po=r+l J_
1.1s (1.1s)' t100
--:-----------=
We have s-ucc,eqdetl.in relating today!,pneg. trd.the forecasted dividends for two years (DIV1 and.
plus the forecasted price at the end of. the second year (&). You will not be surprised to learn that we
go on to replace P2 by (DIV3 + h)l(L + r) and relate today's price to the forecastgd dividends for three
(DlY1,,D'IVi,uiiinitDi\ri}plusthe, i tistadffi
f thd.etrd'ottti€ dfear (P3): In?actri,LCan look as f
into the future as we like, removing Ps as wi go. Let us call this final plriodi.fnir gives us a general
pIVn + Plr
price alw,ayS:e(iialsltl00. r': r''
Assunptions:
1. Dfuidends increase at 1 0olo per year, compounded.
2. Capiklization rate is 15%.

The Value of Common Stocks gl
and DiV
at we
{100
three
,k as far
neral '.',..,1, 6'
;4.:: i. .O
t,
o
Zso
a6
PV (dividends for 100 years)
-o @
PV (price at yearl00)
that the 23410
., 1
Horizon period, years
res at the
different FIGURE 4.1 As your horizon recedes, the present value of the future price (shaded area) declines but the
rp to the present value of the stream of dividends (unshaded area) increases. The total present value (future price and
I stream dividends) remains the same.
erminal How far out could we look? In principle, the horizon period H could be inflnitely distant. Common stocks
do not expire of old age. Barring such corporate hazards as bankruptcy or acquisition, they are immortal.
As H approaches infinity, the present value of the terminal price ought to approach zero, as it does in the final
column of Figure 4.1. We can, therefore, forget about the terminal price entirely and express today's price as
the present value of a perpetual stream of cash dMdends. This is usually written as
,r:i: .
where * indicates infinity. This formula is the DCF or dividend discount model of stock prices. Itb another
present value formula.6 We discount the cash flows in this case the dividend stream-by the return that can
be earned in the capital market on securities of equivalent risk. Some find the DCF formula implausible
because it seems to ignore capital gains. But we know that the formula was derived from the assumption that
p-rt99 in a4y period is determined by expected dividends and capitd, gains ov.er the next period.
. ,,Notice that it is not correct to say that the value of a share is equal to the sum of the discounted stream of
earnings per share. Earnings arg generally larger than dividends because part of those earnings is reinvested
in new plant, equipment, and working capital. Discounting earnings would recognize the rewards of that
investment (higher future earnings and dMdends) but not the sacrifice (a lower dividend today). The correct
formulation states that share value is equal to the discounted stream of dividends per share. Share price is
connected to future earnings per share but by a different formula, which we cover later in this chapter.
Although mature companies generally pay cash dMdends, thousands of companies do not. For example,
Google has never paid a dividend, yet it is a successful company with a market capitalization in early 2012 of
$190 billion. How can this value be reconciled with the dividend discount model?
6l\lotice
that this DCF forrhula uses a shgle &scount rate for all future cash flows. This implicitly assumes that the company is all-equity-financed or that the
fractions ofdebt md equity will stay constant. Chapters t7 through 19 discuss how the cost ofequity chmges when debt ratios chmge.
I'
I
I
I
l
]
Why would a successfri company decide not to pay cash dividends? There are two reasons at least. First, a Usi
growing company may maximize value by investing all its earnings rather than paying out any. The shareholders In th
i.e bett.. off with this policy, provided that the investments offler an expected rate of return higher than share- regu
holders could get by irrvesting on their own. In other words, shareholder value is maximized if the firm invests But'
in projects thai can ."r.r *oi. than the opportunity cost of capital. If such projects are plentifirl, shareholders wort
*lt U. prepared to forgo immediate divldends. They will be happy to wait and receive deferred dividends.T secu
The dMdend discount model is still logically correct for growth companies, but difficult to use when cash .S:
dividends are far in the future. In this case, most analysts switch to valuation by comparables or to earnings- and
based formuias, which we cover in Section 4.4. The;
Second, a company may pay out cash not as dividends but by repurchasing shares from stockholders. We shou
cover the choice berween dividends and repurchases in Chapter 16, where we also explain why repurchases S.
do not invalidate the dividend discount model.8 com

Nevertheless the dividend discount model can be difficult to deploy if repurchases are irregular and unpre- wer€
dictable. In these cases, it can be better to start by calculatinS the present value of the total free cash flow
available for dividends and repurchases. Discounting free cash flow gives the present value of the company as
a whole. Dividing by the current number of shares outstanding gives present value per share. We
cover this
valuation method in Section 4.5. The
secu
The next section considers simplified versions of the dividend discount model.
out I
ffi estnaanrue rHr cosr or eQurv clpltRl- and

west
In Chapter 2 we encountered some simplified versions of the basic Present value formula. Let us see whether g1ve
they oifer any insights into stock values. Suppose,'for example, that we forecast a constant grow& rate for a
company's dMdenls. This does not preclude year-to-year deviations from the trend: It means only that expected
diviJends grow at a constant rate. Such an investment would be just another example of the growing perpetuity
Anr
that we val-ued in Chapter 2. To find its present value we must divide the first year's cash payrnent by the differ-
e,trn
eRce bet',rreen the discount rate and the growth rate:
panl
DIV'
P^
" = r-g
Remember that we carr use this formula only when g the anticipated growth rate, is less than f the discount rate.
Also
As g approaches r the stock price becomei infinite. Obviously r must be greater than g if growth really is perpetual.
equi
Our growing perpetultyformula explains Ps in terms of next yeart expected dividend DIVI, the projected
growth ir."d g und th. expected rate of return on other securities of comparable risk r. Alternatively, the
formula can be ttrrned around to obtain an estimate of r from DIV1, Ps, andg
t: DIVl
*t IfN
o .40 >
The expected return ec,uais the dividendyield (DIV1/Pq) plus the expected rate of growth in dividends (g).
These two iormulas are rnuch easier to work with than the general statement that 'price equals the present
value of expected future dividendsl'e Here is a practical example.
iThe deferred
ceyoLrt !na.y .ome ail ar once if the companl is taken over b,v another. The selling price per share is equivalent to a bmper dividend.
sNotice ihat rve have deriyed ihe diyiden,l discount ncd el wrng clividends per sftare. Paying out cash for repurchases ratier than cash dividends reduces the ----:--
numbcr of shares outstanding and increases tuture earnings and dividends per share. The more shares repurchased, the faster the growth of eunings md
ro
Thi
di'ridencis per shares. 'fhus repurchases benefit shareholders who tlo not sell as well as those who do sell. We show some exmples il Chapter
16' be cor
'r'ihesc rbrmulas rvere first developed in 1938 by \\'illiams and were rediscovered by Gordon and Shapiro. See l. B. Williams, Th e Theory oJ Investment Value 302.U
llln tt
(Carabric,,ge, \1A: Harvairi Univetsitv Press, i9i8); and Nl. I. Gordon and E, Shapiro, "Capital Equipment Analysis: The Required Rate ofProfiti Manage'
rrerrl Scierrcc I (October 1956), pp I 0l 1 I t). in this
secui
L
The Value of Common Stocks Bg
rt least. First, the DCF Modelto Set Gas and Electricity Prices
e
United States the prices charged by local electric and gas utilities are regulated by state commissions. The
,€r than
tors try to keep consumer prices down but are supposed to allow the utilities to earn a fair rate of return.
te frm rat is fair? It is usually interpreted as r, the market capitalization rate for the firms common stock. In other
the fair rate ofreturn on equity for a public utility ought to be the cost ofequity, that is, the rate offered by
.vidends.T
that have the same risk as the utility's common stock.l0
$e when
Small variations in estimates of this return can have large effects on the prices charged to the customers
r to earnings-
on the firm's profits. So both utilities and regulators work hard to estimate the cost of equity accurately.
) noticed that most utilitiesaqe mature, stable compa4igs that pay regular dividends. Such companies
kholders. We
be tailor-made for application of the constant-growth DCF formula.-
r repurchases
Suppose you wished to estimate the cost of equity for Northwest Natural Gas, a local natural gas distribution
rany. Its stock was selling for $47.30 per share at the start of 2012. Dividend payments for the next year
r and unpre-
expected to be $1.86 a share. Thus it was a simple matter to calculate the first half of the DCF formula:
:ee cash flow
DIV1 i.86
)company as. DMdendvield:
,PO - .039. or 3.9%
47.30
Ve cover this:
',. a'f
The hard part is estimating g the expected rate of dividend growth. One option is to consult the views of
security analysts who study the prospects for each company. Analysts are rarely prepared to stick their necks
out by forecasting dividends to kingdom come, but they often forecast growth rates over the next fi-re years,
and these estimates may provide an indication of the expected long-run growth path. In the case of North-
west, analysts in 2012 were forecasting an annual growth of 4.6o/o.tt This, together with the di.ridend yieid,
see whether gaye an estimate of the cost of equity capital:
th rate for a
hat expected r: +Po * g : .o:g + .046: .085, or8.5o/o
gperpetuity
ythe differ- An alternative approach to estimating long-run growth starts with the payout ratio, the ratio of dividends io
earnings per share (EPS). For Northwest, this ratio averaged about 60%. In other words, each year the com-
pany was plowing back into the business about 40% of earnings per share:
Plowbackratio: 1 - payoutratio:
, 1-
-:
EPS
1 - .60: .40
.scount rate.
s perpetual. Also, Northwest's ratio of earnings per share to book equity per share was about 11-clo. This is its returr: on
e projected equity, or ROE:
atively the Return on equity : ROE
EPS
: .11
book equity per share
If Northwest earns 11% of book equity and reinvests 40o/o of income, then book equity will increase by
.40 x .11 = .044, or 4.4o/o. Earnings and dividends per share will also increase by 4.4o/o:
rds (g). :.044
Dividendgrowthrate:g: plowbackratio X ROE:.40 X .11
he present
That gives a second estimate of the market capitalization rate:
DIVr
, : -h + g : .o:g + .044: .083, or 8.3o/o
dend.
rds reduces the
f eanings md r0
This is the accePted interpretation of the U.S. Supreme Court's diective in 19,14 that "the returns to tle equity owner fof a reguiated business] should
' 16.
be comensurate with returns on investments in other enterprises having corresponding risks." -Federal Power Commission v. Hope Natural Gas Company.
/estment Value
302.US. 591 at 603.
ofrtl' Manage- rrln
this calculation wdre assming that ernings and dividends ue forecasted to grow forever at the sme rate g. We show how to relu this assumption later
in this chapter. The gron{h rate was based on the average eanings growth forecasted by Value Line and IBES. IBES compiles md averages forecasts made by
security analysts. Value Line publishes its own malysts' forecasts.
ExamP
long-term comPal
years
the multistage DCF model, growth after five
TABLE4.SCost.of-equityestimatestgr|o9a]gasdistributiongompaniesatthestartof2012.The
ln ofequi
orowth rate is based on security analysts' .forecasts.
Lassumedtoadiustgraduallytotheestimat"oIong-il;n}.ili.
is
lqng-te
but tht
thb anr
The ar
t 4,50/o 5.0% e.4Yo 9.3%
Atmos Energy CorP. I
$32.42 $1.45
2.8 7.0 I
8.5
caPital
4.2
The Laclede GrouP lnc. I
40.74 ''111 ,
5.4 8.7
I
8.2
So
1.60 3.3 I
consta
48.07
New JerseY Resources Corp' 12.5 10.0
I
4.3 8.2 switct
i.00
Nisource lnc. I
22.95
4.6 8.5
I
l 8.7
47.30 1.s 3.9
Northwest Natural Gas Co' 7.8 8.3 DCF
3.7 4.2
Piedmont Natural Gas Co'
South Jersey lndustries lnc'
32.98
55.08
1.21
1.76 3.2 I n.o 8.8 Po ='

I
mean
114 2.7 I 7.8 10.5 8.0
Southwest Gas CorP.
WGL Holdings lnc.
41.61
43.20 .1.63 3.8 I

I
s.s 9.1 8.7
9.5o/o 8.7o/o
I Average:
.' The t
Sour0sTheBffittlecroup,lnc. - . :
a
Annualized last quarterly dividend'
Long-term GDP growth forecasted at
b 4'70lo
, s of Northwest! cost cif equity seem reasonab-le,

there'are obyious dangell in analyzing Butl
;a;'rv,1g assurnption or regurar
ff:frl.}ffi:Tfrtffi';;-;;i* sr"*,h'o6r royura. Fi1s1, tr'9 approximation' errors inevitably con(
future growth is best an

s".s";;;iil;;
at appro4imati,o.1. 4cceptable ,l
denl
---d.rri"*U.r,
Northw"?'s cost of eguity is;not its
personltr PIoP€9; .s0:
ctars at exactb/ the same rate. But
any
capitalize,h.;;;;,;i;+;:"rru", in'Nortrr*.rt! rist .?
investors practice does not put too much
estimate of r for u ,irrgt. .o*-on stoek
is "noi"f; *J
error'Good
r
<2,i
'uUiect,to of similar companies' estimates
of the cgst ff .qrray !.91ects samples Aft,
weight on single-comp*y
for each, and takes an aYerage. The average
"Jry";
gi,nes more reliable benchmark
for decision making. .16,
" has
Thenext-to-lastcolumnofTable4.3givesDCFcost-of.equityestimatesforNorthwestandsevenothergas
tleSonst=f.sro$-DCF formula
&stribution .o*purri.* iir.se are all r,itt", -"L. **p#",
for
lhich of the variation may reflect differ- TAI
cost]oiequiryestimatelt fome
ought towork Notice the variation in the
ear
just noise' The average estimate is 9'5%' inr
ences in the risk, but some is ' several as
Estimatesofthirk their forecasts tlnd to be over-
"il:':rlry;;;ffi;GLr-*f-ecastsonwtric,hthevarebased.Forexample,
and
to behavioral biases
studies have observed that security:analy'sts:are ffieci
pcp estim#s o-f tire ."rt ,ildJar rt u. guta"a as upper esti'rnates of the true figure'
t
optimistic.ff so, ,o.r, "otJ
Dangers Lurk in Constant-Growth Formulas t
O
but no moreithan that' Naive 'l
The simple constant-growth DCF formula
T:*"T:,Y:t-*.**thumb' .I
tilly,to:tqt':"^t.
analyststo
;t, i",h. formda hL led many financial
iirff.':i*:Jili'iilHl#:ru1ffi#;; ;lffiil;;".,".k ":rr:'r;:J:: :lfl *':Ty."i."';
;;
.-"X""'!il:'fi'::::':il'H:Xi#n;.Ti':1yf,*i**t.T#J::tr*',::tfliff#:e'because
,;,'i ,o uiu*" out across a broad sample'
;f:';ffi:r',X,:,'J','X'll;il;i#'i;;"i;il;;;,'y
,T,T:::hTl""[ff ilffi f :JJ;';ffi H,i";;ffi ;;#i;i:::*::"'=:l'"'""S.:t:].:'""#
a i i-- L:-L -.,+*aat *rto" nf orowth- SU
.#lrliil'JffI',.'ffi:',#;f:tF;;;*Gi"*r, nir rirmura assumds it

can. rhis erroneous
assurnption leads to aii overestimate of

r'
I
i
The U.S. Surface Transportation Board (STB) tracks the "revenue adequacy" ofU.S. railroads by
, long-term
five years ing the railioads' returns on book equity with estimates of the cost of the equtty. To estimate the cost
in" Stg traditionally used the constant-growth formula. It measuredgby stock analysts' forecasts of
r earnings growth. The formula assumes that earnings and dMdends grow at a constant rate forever,
r analysts' "long-term' forecasts looked out five years at most. As the railroads' profitability
improved,
became more and more optimistic. By 2009, their forecasts'for growth averaged L2.5o/o pet fear.
average dividend yield was 2.60/o, so the constant-growth model estimated the industry-average cost of
9.3%
8.5 ai2.6+ 12.5= l5.lo/o.
8.2
:
)'t!-
the STB said, in effect, "Wait a minute: railroad earnings and dividends cant grow at12.5o/o forever. The
-
0.0 ilit""t-g**+ formula no longer works for railroads. We've got to find a more accurate method." The STB
to a two-stage grorarth model, which we now discuss.
1.7
DCF Models with Two Stages of Growth Consider Growth-Tech, Inc', a firm with DIVI =
L3 1.50 and
1.8
{50. The firm has plowed back 80%o ofearnings and has had a return on equity (ROE) of 25%o. This
Po =
i.0
means that in the Past
.7
,70/o Dividend growth rate : plowback ratio x ROE : .80 X .25 : .20
The temptation is to assume that the future long-term growth rate g also equals .20. This would imply
r: .50
* .20 : .21
50.00
ralyzing -
regular But this is silly. No firm can contilue growing at 20% per year forever, except Possibly under extreme inflationary
evitably conditions. Eventually, profitability will fall and the firm will respond by investing less.
In real life the return on equity will decline gradually over time, but for simplicity let's assume it sud-
narkets denly drops to 160/o at year 3 and the firm responds by plowing back only 50% of earnings. Then g drops to
]ut any .50x.16=.08.
r much Table 4.4 shows what's going on. Growth-Tech starts year 1 with book equity of 110.00 per share. It earns
nates r 12.50, pays out 50 cents as dividends, and plows back T2. Thus it starts year 2 with book equity of T 10 + 2 = TL2.
After another year atthe same ROE and payout, it starts,year 3 with equity of { 14.40. However, ROE drops to
her gas .16, and the fiim earns.only {2.30. Dividends go up to 11.15, because the payout ratio increases, but the firm
irmrila has t 1.15 to plow back. Therefore subsequent growth in earnings and dividends drops to 8%.
only
differ- TABLE 4.4 Forecasted earnings and dividends for Growth,Tech. Note the changes in year 3: ROE and
earnings drop, but payout ratio increases, causing a big jump in dividends. However, subsequent growth
ieveral in earniirgs and dividends falls to 8% per year. Note that the increase in equity equals the earnings not paid out
I over-
lgure.
Book equity 10.00 12.00 14.40 15,55

Naive
Earnings per share, EPS 2.s0 3.00 2.30 2.49
Return on equity, ROE .25 .25 .16 .16

ile of
Payout ratio .20 .20 .50 .50
lause
Dividends per share, DIV .50 .60 1.'t5 1.24
:wth GroMh rate of dividends (%) 20 92 I

eous
l
Now we can use our general Tt
"t^tt"tgi;, DIV, Dfvs" + p3 al
Pn:
-u ---------: + -------:-: +
l*r (t+r)z (l*r)3
Investors in year 3 will view Growth-Tech as offering SZo p., year dividend growttr. So we can use the
constant-growth formula to calculate P3:
DIV,
tl-r-ng
D-
^
ro : DIVI DIVz - DIV3 * I DIV4
t + r- 1r * 4 1, * ry 1, *.y " .-.08
: '50 'uo
* (L*r)z 1'15=*--1-.--x L'24 I
l-rr =+(1:tr)r (1*r)i r-.08 II
ci
We have to use trial and error to find the value of r that makes Pe equal 150. It turns out that the r implicit in b
these more realistic forecasts is approximately.0gg, quite a difference from our'tonstant growttf estimate of .21.
Our present value calculations for Growth-Tech used a two-stage DCF valuation model. In the fust stage sj
(years 1 and 2), Growth-Tech is highly profitable (ROE : 25o/o), and it plows back 80% of earnings. Book E
equity earnings, and dividends increase by20Vo per year. In the second stage, starting in year 3, profitability v
and plowback decline, and earnings settle into long-term growth at 87o. Dividends junip up to 11.15 in year 3, (i
and then also grow at 8%. tl
Growth rates can vary for many reasons. Sometimes growth is high in the short run not because the fum ir
is unusually profitable, but because it is recovering from an episode of low profitability. Table 4.5 displays
projected earnings and dividends for Phoenix Corp., which is gradually regaining financial health after a
near meltdown. The companyt equity is growing at a moderate 4%. ROE in year 1 is only 4%, however, so
Phoenix has to reinvest all its earnings, leaving no cash for dividends. As profitability increases in years 2 and
3, an increasing dividend can be paid. Finally, starting in year 4, Phoenix settles into steady-state growth, with
equrty, earnings, and dividends all increasin g at 4oh per year.
Assume the cost of equity is 10%o. Then Phoenix shares should be worth T9.13 per share:
*t'o: 0 * .3i * .6s *,tryI * qro-r+y
.67
:te'I3
r.1 *y ur,,
-E(ffii6Md") : E('..",dGrdrdd."d-)-
You could go on to valuation models with three or more stages. For example, the far right column of Table 4.3 l
presents mlltistage DCF estimates of the cost of equity for our local gas distribution companies. In this case the r
long-term growth rates reported in the table do not continue forever. After five years, each company's growth c
rate gradually adjusts to an estimated long-term growth rate for Gross Domestic Product (GDP). t
We must leave you with two more warnings about DCF formulas for valuing common stocks or t
estimating the cost of equity. First, it's almost always worthwhile"to lay out a simple spreadsheet, like
Table 4.4 or 4.5, to ensure that your dividend projections are consistent with the cornpany's earnings c
and required investments. Second, be careful about using DCF valuation formulas to test whether the
market is correct in its assessment of a stock's value. If your estimate of the value is different from that
oi the market, it is probably because you have used poor dividend forecasts. Remember what we said at
the beginning of this chapter about simple ways of making money on the stock market: there aren t any.
Forecasted earnings and dividends for Phoenix Corp. The company can initiate and increase dividends
not paid out as dividends.
{ROB recovers. Note that the increase in book equity equals the earnings
IN USE
THE LINK eerryEEN STOCK PRICE AND

or, ,.pur"t growth stocl<s from income stocks. Th.y luy gowth stocks primarily for the expectation of
I eains, and they afe interested in the future gfowth of earninlgs rather than in next year's dividends. They
nplicit in stocks primarily for the cash dividends. Let us see whether these distinctions make sense.
tte of .27. first the case of a company that does not grow at all. It does not plor^r back any earnings and
irst stage ,duces a constant stream of dividends. Its stock would resemble the perpeiual bond described in
gs. Book ,ie, Z. R.n e.rrber that the return on a perpetuity is equal to the yearly cash flow divided by ihe preseni
:. So the expected return on our share would be equal to the yeariy dividend divided by ihe share
price
fitabiliry
n year 3, the dividend yield). Since all the earnings are paid out as dividends, the expected reiiirl is also equal to
earnings per share divided by the share price (i e., the earnings-price ratio). For exampie, ii ihe 'lividend
the firm 10 a share and the stock price is tI00, we have"
displays
Expected return :-dividendyield : earnings-price ratio
L after a
ever, so DIV1 EPS1
:s 2 and DD
r0 r 0
'.h,with
10.00 1n
-
-.r1,
100
The price equals

DIV. EPS, 1O.OO :100
Pn::
"rr.I0 -
ble 4.3 The expected return forgrowingfirmscan also equal the earnilgs-price ratio. The key is whether'eailiit:$s alt
rse the reinvested to provide a return equal to the market capitalization rate. For example, suppose otlr iionoionous
rowth company suddenly hears of an opportunity to invest t 10 a share next year. This wodd mean no dividend at
t= l. However, the company exfe.ts that in each subsequentyear the project woui<i earn {1 per share, and
:ks or therefore the dividend could be increased to t I 1 a share.
:, like Let us assume that this investment opportunity has about the same risk as the existing business. Then
r've
nings can discount its cash flow at the 10%o rate to find its net present value at year 1:
rr the
L that Netpresentvaluepershareatyear I : -10 *
1
: 0
Lid at -
any. l2Notice that we use next yeil's EPS for E/P md P/E ratios. Thus we are using forward, not trailing, P/E
TABLE 4.6 Effect on stock price of investing an additional tl0 in year 1 at different rates of
return. Notice that the eainings-price ratio overestimates r when the prolect has negative NPV and l
underestimates it when the project has positive NPV. fiar
.EPq th,.t
,- [Rcremontal .'Prcjecils lmpacl oir ,, 'sharePrice in grol
. CashFlout,C Slrarg Price in Year 0b ', Year Sn Po
' ,P,o. ' r
.05 <.50 -t5.00 -<4.55 t 95.45 .105 .10
,10 't.00 0 0 100.00 .10 .10
.15 1.50 + 5.00 +4.55 104.55 .096 .10
.20 2.00 +10.fi) +9.09 109.09 .092 .10
a
Project costs <10.00 (EPS1). NW = -10 + C/i where r= .10.
b
NPU is calculabd at year 1. To find the impact on P0, discouni lor one year ai r= .10.
Thus the investment opportirnity will make no contribution to the coinpany's value. Its prospective return
is equal to the opportunity cost of capital.
What effect will the decision to undertake the project have on the company's share price? Clearly none.
The reduction in value caused by the nil dil'idend in year 1 is exactly offset by the increase in value caused by
the extra dividends in later years. Therefore, once again the market capitalization rate equals the earnings-
price ratio: But
,- EPS1 10 tors
:.10 .I
Po 100
?ta
Table 4.6 repeats our example for different assumptions about the cash flow generated by the new project. star
Note that the earnings-price ratio, measured in terms of EPS1, next year's expected earnings, equals the mar-
ket capitalization rate (r) only when the new project's NPV : 0. This is an extremely important point-man-
agers frequently make poor financial decisions because they confuse earnings-price ratios with the market
capitalization rate.
In general, we can think of stock price as the capitalized value of average earnings under a no-growth
policy, plus PVGO, the net present value of growth opportunities:
Po: IIS' + PVG.

r
Thu
The earnings-price ratio, therefore, equals ofe;
EPS
: PVGo) eacl
Po\Pol
'( '- first
It will underestimate r if PVGO is positive and overestirnate it if PVGO is negative. The latter case is less likely,
since firms are rarely forced to take projects with negative net present values.
The
Galculating the Present Value of Growth Opportunities for Fledgling Electronics <2.,
In our last example both dividends and earnings were expected to grow, but this growth made no net contribution offi
to the stock price. The stock was in this sense an "income stockl' Be careful not to equate firm performance with diyi
the growth in earnings per share. A company that reinvests earnings at below the market capitalization rate r
may increase earnings but will certairily reduce the share value.
L-
The Value of Common Stocks S5
DIV,
.j: 5
P6: = ?100
r-g .15 - .10
that Fledgling has earnings per share of EPSI = t8.33. Its payout ratio is then
DIV,
Payout ratio : : -.6
=-
EPSl
,. : .In other words, the company is plowing back 1 - .6, or 40o/o of earnings. Suppose also that Fledglingt ratio of
,i.rnirgr to book equity is ROE = .25. This explains the growth rate of 1070:
Growthrate : g: plowbatkratio X ROE : .4 X .25 = :10
ive return
' T e capitalized value of Fledgling's earnings per share if it had a no-growth policy would be
rly none.
:aused EPSl 8.33
by ?55.55
arnings- r .15
' But we know that the value of Fledgling stock is t t00. The difference of t44.44 must be the amount that inves-
tors are papng for growth opportunities. Let's see if we can explain that figure.
, at a permanentZlo/o return on equrty. Thus the cash generated by this investment is .25 x 3.33 = t.83 per year
,starting at t = 2. The net present value of the investment as of f = 1 is
pro;ect,
he mar-
NPV, : -'3.33 1-
.83
: ill ))
-mar!- .15
markef
Everything is the same in year 2 except that Fledgling will invest 73.67, l0o/o more than in year I (remember
growth g=.10). Therefore att=2 an investment is made with a net present value of
\rnr,
NPV2: ^__+ .93x1.10 :72.44
_ -3.67
15
Thus the payoff to the owners of Fledgling Electronics stock can be represented as the sum of ( 1 ) a level stream
of earnings, which could be paid out as cash dividends if the firm did not grow, and (2) a set of tickets, one for
each future yeiu, representing the opportunity to make investments having positive NPVs. We know that the
first component of the value of the share is
tik"ly, EPS,
: -; : 8'33 :
Present strei ofearnings
resent value oflevel stream {55.56
;
The first ticket is worth12.22 in f = 1, the second is worth <2.22 x l.lO = T2.44 in t = 2, the third is worth
lZ.++x 1.10 = 12.69 in t = 3. These are the forecasted cash values of the tickets. We know how to value a stream
rtion of future cash values that grows at 10o/o per year: Use the constant-growth DCF formula, replacing the forecasted
with dividends with forecasted ticket values:
ate r
Presentvalue of growth opportunities PVGO
NPV1
: --:--.: : .---
2.22
= r_g .15_.10 =<M.4
.:
:96 , Prinaiples,of Corpordte Finahce
,, Nowlqverf-th-i-4g,,6h€cks: :,,,-:.'
Share priee :'pres'enivalue oflevel Stfeam of earnings

.,, -, . :., * presentvalugofglolyth
'' '. l' '='-{,lli'i:
,
, pvco,t ':::":"',,
r
1
;t : T5s.s6 + <44.44
+
,.
E
: tl00
E
ai
Why is Fledgling Electronics a growth stock? Not because it is expandin gat l0o/o per year. It is a growth st
E
g: because the net present value of its future invistments accounts for a significant fraction (abouie+X) of
i:
!E
stoclCs pqice.
'*. Toduyt stock price reflects ihvestor orpectations about the earning power of the firm's current and
s. fat
8,,. , assets. Thke Google, for example. Google has never paid a dividend. lt ptows tact aU its earnings into its busin
B:::
E]: : In |anuary 2012, its stock sol{,for$5!0perphargat a forward P/E ofabout 14 EPS forecasted for 2012 wefe M2
Eil-,::',:
tri: :':.:j Suppose that Google did not grow, and that future EPS were expected to stay constant at $112.30. In this ,
El',:_
Googlecouldpay.a,sons]ant dividend of $42.30 pel share,.If.the cqqtqf equity,ls'salr.-t? .marfretvahrg,v
5i.ir,'
be PV = 42.301.12='$353 per shar€, 9227less thar.r the aituais1.o,,_cJlprici of SSS0. thii rnyestors
ili..i:.
S:-'ir:"j', :
Soit appgar,q
!.:j:,':..
valq4g Googles future investmtnt oppor.tu4itigs at'$222 per-ihare, qlrnqst of the stock p.rce. Coogi.
40o/p
5::- :: :::
a.r .' r,r': growth stockbecause thatlarge ftac.tion ofai marketvalue comes from the g4peaed NPV oiits future investrnr
E:j. 1l
?:.::..
i:: ', '

VALUING
t. ,.'
Inves'tors buy ni:b€li'shares,6f aommohtfodc,,€otnpanigs often bur.or sellrentire,businesses,or,rnajor stak6l
i
businesses. For example, we have noted Kinder Moqgan's plans to sell its El Paso exploration and production subsidia
i-:: Both Kinder Morgan and potential bidders were doing their best to value that business by discounted casn now.
DCF models work just as well for entire businesses as for shares of common stock. It doesn't n
whether you forecast dividends per share or the total free cash flow of a business. Value today always
future cash flow discounted at ttre opportunity cost of capital,.
:. .
low
we will see, free cash flow can be negative for rapidly growing busiaesses.
Table 4.7 is similar to Table 4.4, which forecasted earnings and dividends per share for Growth-
based on assumptions about Growth-Tech's equrly per:sh*",,oet rrn on equity, ana tf,e growth of its busi
For the concatenator business, we also
lave assumptions about assets, pr.ofitability-ln this case,
operating earnings relative to assets-and growth. Growth starts out at a rapid lTVo pet y€ar, then
twostersto a,moderate S-%late:fur.thelongrun. The $owth rate determinedthe,netaildiiioadinv_,
required to expand assets, and the profitability rate determines the earnings thrown offby the business.
Free'cash flow, the fourth line in Table 4.7, is,equal to thi'firu,t's Jarnings:t1"sst.aq1,1gf.invsctr!
expenditures. Free cash flow is zero in years I to 3, even though the parentr company is investing
{3 million during this period.
;r,
i 4t7 Forecasts of free cash flow in t millions for the concatenator division, with input assumptions in ,
ce type. Free cash flow is zero for periods 1 to 3 because investment absorbs all of net income. Free cash flow
irositive when growth slows down after period 3.
7 I I 10
10.00 11.20 12.54 14.05 15.31 16.6S 18.19 19.29 20.44 21.67
1.20 1.34 1.51 1.69 1.M .2.00 2.18 2.31 2.45 2.60
rwth 1.20 1.34 1.51 1.26 1.50 1.09 1.t6 1.23 1.30
4%) of the
0.00 0.00 0.00 0.42 0.50 1,09 1.16 1.23 1.30
xnd
sbu 0.12 0.12 0.12 0.12 0i2 0.12 0.12 0.12
:re $42.30.
t this case
lue would 0.12 0.12 0.09 0.09 0,0S 0.06 0.06 0.06
itors were
rogle is a
estments. 0.12 0.12 0.09 0.09 0.0g' 0.06 0.06 0.06
Starting asset value is t1 0 million. Assets grow at 1 2% to start, then at 9%, and finally at 6% in perpetuity. Profitability is assumed constad at 1 2%.
rtakes in Free cash flow equals earnings minus net investment. Nel investment equals total capital outlays minus depreciation. We assume lhat investment lor
bsidiary. replacement of existing assets is covered by depreciation and thal net investment is devoted to growth, Earnings are also net of depreciation,
x,t{ Are the early zeros for free cash flow a bad sign? Nor Free cash flow is zero because the business is growing
matter rapidiy, not because it is unprofitable. Rapid growth is good news, not bad, because the business is earning
; equals ),2o/o,2percentage points over the 1070 cost of capital. If the business could grow at 20%o, Establishment Indus-
tries and its stockholders would be happier still, although growth at}}o/o would mean still higher investment
ta' and negative free cash flow.
:turing
Valuation Format
:oblem The value of a business is usually computed as the discounted value of free cash flows out lo a valuation horizon
(Fl), plus the forecasted value of the business at the horizon, also discounted back to present
value. That is,
,iq ttre FCFI FCF' FCFH PVs
th,,Ar
PV: t (t+r)'.+...+ (I+r|H -f
!+, (1 +;)H
:' pv(n".]l[Eil- pvEi.il'=iio.)
:Tech,
Of course, the concatenator business will continue after the horizon, but it's not practical to forecast free cash
iness.
flow year by year to infinity. PVs stands in for free cash flow in periods H + l, H + 2, etc.
ir-tax Valuation horizons are often chosen arbitrarily. Sometimes the boss tells everybody to use 10 years because
kin that's a round number. We will try year 6, because growth of the concatenator business seems to settle down
IrlF-itt
.: to a long-run trend after year 7.
nent Estimating Horizon Value

'over
There are several common formulas or rules of thumb for estimating horizon value. First, let us try the
constant-growth DCF formula. This requires free cash flow for year 7, which we have from Table 4.7;
a long-run growth rate, which appears tobe 6o/o;and a discount rate, which
some high-priced cr
told us is 10%o. Therefore,
(r.r/-
(1.1)6
The PV of the near-term free cash flows is T.9,million. Thus the present value of the concatenator
division is,
" ' :'PV(biusiness) ;
PV(freecashflow)' * PV(horizonvalue) :'' , ':'', '
,,i ', =0.9,+\5A,' I ,...::
:
?16.3 miltion
Noti' are,we.do.ne? Well, the meehraaics ofthis calculatisn are perfec!. Butdoesnt it make you just a little.
;;;;; f-;;i,;;G,r-*,'
Eaq,changq&amatically rn rerpont. io
lor:3on.value lirparently tqinor clanges in'assuniptions;F'or,ex:r
the long-qungroli
+L;ll:r;.*-'' ;î:*L .:'L'.t-
a^)
is
7o/p
.i- . .r
latherthano%, thevalqg'of the;b-usineis incleases from tio.3.to ttc:,,; ;;
In other words, it's easy for a discounted-cash-flow business valuation to be mechanically perfect
f
pracllcally,wrgng. Smar-tfinanc!41-managerstryto check their results by calculating horizon value in
ways.Let'stryvaluationbycompara$ls;,using,pfE.and,market-bool<ratios. ,t .
rc;ulan,t u
Horizoh liiuegastabn ze n11!9s Supp919 i for ma re'manufaclu4qg,con
niai*rroie$ilii'k-fiias'@pi"spa.t'iiaaifra,iiflnl'"it
year
h'lqo-ckpri
;a='i;i*Jf".rh.;;;;;",Inu,,.inu,
Supposl fii-r1]rer that these cornpanigstend to selt at price-qa4ings ratios of about 1 1 . Then you could
!,
sonably guess that the price-eamings ratio of a mature contatenator opJration will likewise Ue r r.
fnat impt
'
13.s
PV(business) : :
:9 * 13.5 (14.4 million
, Horiion,valueBased on Maf ket:Eook Eatiob .. suppose
Suppose alio'
also that.the market-book ratios of the sample
that the marker :
lltrll mam turihg companies tend to,cluster aroirnd 1.5,,If the concaten;* U*iit"si;i.;i;O';;
is 1.5 in vear 5. I
PV(horizonvalue) : X 16.69) : l4.t
ffi(t.S
..
PV(business) :
.9 + 14.1 =,t15.0 million
It's easy to poke holes in these last two calculations. Book value, for example, is often a poor
measure of th
true value oja company's assets. It can fall far behind actual asset values when there is rapid inflatio",
;;
.*i..hmissesirnpcrtant intangibtq assets, such as your petentq for concatenator aJsg",;J""ingsma
".ft.:-
also be biased by inflation and a long list of arbitrary accounting choices Finally, you
o.u.ik ,o* *frln y,
have found a sample of truly similar companies to uie as compaiables.
But remember. the purpose'of discounted cash flow is to estimate qarket value-to estirnate
-.-.IJ ? .
what i
would pay for a stock or business. When you.can olserve whatthey aauallv pay for simil*
.o*p*i.r;
$l"lk evidence. Try to figure. out.a way to use it. one way to use it ir trl-ug},
' -l'
basedo4 p-rice'eainings or market-book - .:: .,': '- :- :- ; -- --=O-- '-:-_-.-'YI :Y.::'t.=-!
,"il;;;y;;
ratios. Valuaiion,ruleg;of thumb, a4fu[y emp1oy.a, ,o-.ti*ei
^ complex
-^--l--- f!- - . t
a discounted-cash-flow calculation hands down.
tsIflong-m growth is 7%
hstead of6%, m stra l% ofasset value will have to be plowed back into the concatenator business, reducing free cash flow
tl.09milliontot.97miIlion.ThePVofcashflowsfromdates1to6staysatt.9million.
Horizon value (discouted back to pV d"t" o;

'97
"t =-! = tre.3 million
(l.r)6" .ro -.07
'' PV (buiness) = O.g +18.3 = f 19.2 miUion
The Value of Common Stocks gg
sultant has
A Further Reality Gheck
Here is another approach to valuing a business. It is based on what you have learned *Yv$!rrr!v
!a
about price-earnings ratios
.on andthepresentvalueofgror,vth opportunities
' suPPose the valuation horizon is set not by looking for the first year of stable growth, but by asking when
the industry is likely to settle into competitive equilibrium. you ,iritrri g, to the
operating manager most
familiar with the concatenator business and ask
r.ision is
', " sooner or later you and your competitors will be on an equal footing when it comes
to maior new
investments. you may stilr be.earning a superior ..to.n
in yo* ."?. urri""rr,'i;;; il;;,ri il;
' , thaj introdyaions of new proa".t ot""u"#pts to orpand sales
of existing products trigger intense
' resistance from comgetitgrs wh9 are just about ,r #urt
in.i."a /vq ns'
as you
-rr' eo *J
are. \,vs
Give a rE
realistic
: nervous
assessment of when that time will come.
s thatthe pvGo, the net present value
:ample, if ;rl*:Ti;:*:T:::L*:1p:n of subsequent growrh opportunities, is
nillion.t3 fii:*',*::::::'":','ji:::,:'ryj::::yll:ru..*p..,.J'o-""*=;;;.";;;;.ffiffi;,;;:
Wt:1To"r competition catches up, that happy prospect disappears.
fect and
__-Y:
ho* that present value in any period equals the capltalized
v"lu. of next periodt earnings, plus
lifferent PVGO:
rv,:3tntn9t':-l+PVG.
comPa- r
riness in But what if PVGO : 0? At the horizon period H, then,
uld rea-
earningsn+
nplies: PV6 : t
:
r
In other words, when the competition catches up, the price_earnings
ratio equals 1/r, because PVGO
disappears.la
Suppose that competition is expected to catch up
in period 7. Then we can calculate the horizon value at
period 6 as the present value of a level stream of .u.rirrg,
rple of ,t".ti.rgi, v o p.;i od7 andcontinuing indefinitely.
< ratio
resulting value for the concatenator business is: 'rb'rr The
:
U+, (=="i*)
PV(horizon value)
f the r / zta\
ndit (r.r)6 \ ,ro / i
may
you : {12.3 million
itors
pV(business) : .9 + t2.3 = t13.2 million
hatir we now have four estimates of what Establishment Industries
iles, ought to pay for the concatenator business.
The estimates reflect four different methods
)eat of estimating horizon lrllrr". Th.r. is no best method, although
I
l{In 1
other words, we can calculate horizon valire 1

as feraings will not grow after t}re horizon date, :
because growth will add no value. But what does .,no i
Srowth" mean? suPpose that the concatenator business maintLs
its msets and earnings il real (inflation-adjusted) terms. ,l
Then nominal eunings will grow
takes us back to the constmt-gro.th formul",
eanugs in peiod H + r ,ioJa ue uutued by dividing by r g
lff.H:ffi:t:]is - where g in this cme l
we have simplified the concatenatot exmple' i
In realJife valuations, with big bucla ilvolved, be crefrrl
n'ai"v *Jc' i*"u ;J*."a
to track grofih from inflation as well as
$o!r,th i
H?,ffitffff;fl1:;ffi:;J' ,"aatioi and the constant-crowth valuation Modeli
/oar nat of Apptied corporate i
4
*
3
s
-.8
'100 Principles of Corporate Finance
we like the last method, which sets the horizon date at the point when management expecis,PV.G$::
disappear. The last method forces managers to remember that sooner or later competition catches up.
Our calculated values for the concatenator business ra4ge fropq,IgJ.fo t163.mjllior,.4{,!{ftrguqe
about t3 million. The width of the range may be disquieting, but it is not unusual. Discounted
formulas oalyistirqa@ m4rket value, and the estimate5 challge as forecas-ts an{ assumptions change. Manag
cannot know m"rket value for sure until an actual transaction takes place.
free Cailr-flow, Oivloends, and Repurcfti*i"

We assumed that the concatenator business was a division of EstablishmenL Industries, not a
corporation. But suppose it was a'sepatate corporation with I million shares outstanding. How:worild
calculate price per share? Simple: Calculate the PV of the business and divide by 1 million. If we decide that
business is worth t 16.3 million, the price per share is t 16.30.
l
If theconcatenator business *are a public Concateiiitor Corp., with no:other'aisets'and'operatioiis,
could pay out its free cash flow as dividends. Dividends per share would be the free cash flow shown
Table 4;7'divided by 1 million shares: zero in periods'1 to 3, then t.42 per share in period 4,'1.+6 per sha
We mentioned stock repurchases as an alternative to cash dividends. If repurchases are important, it's
simpler to value total free cash flow than dividends per share. Suppose Concatenator Corp. decides not to
cash dividends. Instead it will pay out all free cash flow by repuichasing shares. The market capitalization
the company should not change, because shareholders as a group will stilt receive all free cash flow.
Perhaps the following intuition will help. Suppose you,own all of the 1 million Concatenator shares.
you care whether you get free cash flow as dividends or by selling shares back to the firm? Your cash
in each future period will,always equal.the:free cash flows shown in Table,4.Z,Your DCF,valuatisnof
company will therefore depend on the free cash flows, not on how they are distributed.
ChapGr 16 covers the chsice between:bash.dividends and:repurchases.(including-tax,issues and other,
conpiiaations); Butyoucauseewhyitis attraetive,to value a company as.awholeby,forecastinganddiscounti
free c.ash flow. You dont haveto ask how free cash flow wiil be paid out,,You don t have to forecast repurc
I survrMARY
In this chapter we have used our newfound knowledge of present values to examine the market price of common
stocks. The value of a stock is equal to the streirm of cash pa).nents discounted at the rate of return that investors
exPecttoreceiveonother,..,,,iti.,withequivalentrisks.-
Common stocks.do not have a fixed maturity; their cash payments consist of an indefinile stream of dividends:i
Therefore, the present value of a share of common stock i-s
& DIV.
pV : }, :",-,..
/:r(t + r)'
However, we did not just assume that investors purchase common stocks solely for dividends. In fact, we began with
the assumption that investors have relatively short horizons and invest for both dividends and capital gains. Our
fundamental valuation formula is, therefore,
ro- 't
r*r
This is a condition of market equilibrium. If it did not hold, the share would be overpriced or underpriced, and
investors would rush to sell or buy it. The flood of sellers or buyers would force the price to,adiust'So,that'the
fundamental valuation formula holds.
We also made use of the formula for a growing perpetuity presented in Chapter 2. If dividends are expected to
grow forever at a constant rate ofg, then
The Value of Common Stocks l0l
ts PVGO ffi. DIV,

Po:
li{ference
ffil r-s
and use it to estimate the market capitalization rate 4 given Ps and
ffit** Oelpful to tr,vist this formula around
d-cash-flow
e. Managers,
ffiil.'"iiin',;uu
ffi ,. ,:-h
-
DIVr
--
-E
;;;.', tu'*{.":".1'-'\:::: ::::,::':TtiT,:?::t*:*1i'i1-i:fi"fl?,ffitT

however, that this
#'ffiil;;.:,ilti;;;';;i"" .. T1Tli ,:i::1gT,i1i:,,i:":l-::1':,::,::-:":ilf"'"fJ:
ieestanding
, would
Hi,flil&;iq;:,,i;i;:;;;, d;;;v;,:]:"^:?1i1,"1:!::':,2'.:Yi'":::i:"1'ffi:':il,:::fiil::,X: start
we:
ffi'i'ffi'il.',ffi,;;;d;'.*';;;"'Il'.!lllTli::f:i::.t:::T::*:":y:""i*::1ffi:::the
ide that the :?ff$il;i;;;;.*-,*;a-,,ai"aJi1a'n:11i::T::*:.*l:::i::'""X.1*::l;"i:::ff;
ffi"rru;;-F il;;;; be transformed rnto a etatement 4bout
ealqings and gro-wth opportunities:
:'a,
erations, it.
,shown in",
) Per snare
Epsl/r is the present value ofthe earnings per share that the
firm would generate under a no-growth pol-
The ratio
in order to grow' A growth stock is one
:-,, pVGo is the net Dresent value of the investments that the firm will make
stocks are stocks
t, it's often ,
#ffi;;ir;;1;il;;;",ive to the present value of EPS, assuming no growth. Most growth
high PVCO' What matters is the profitability of
not to Dav expanding fi."r;,;; e*purrsion alone does not create a
of rapidly
lization of. the new investments. that case'
The same formulas that we used to value
common shares can also be used to value entire businesses' In
by the business. Usually a two-stage
hares. Do not dividends per share but the entire free cash flow generated
we discount
out to a horizon and discounted to present value' Then a
:ash flows DcF model is deployed. Free cash flows are forecasted The sum is the value of the
on of the horizon value is for".u.t d, di.counted, and added to the value of the free cash flows'
business.
ffiL, a business is simple in p.in.ipl. ;but*"1'1f
no1 so elsv in nractice-,f1;::t11cJ::::1"YL?t1:.^:.'::j:?
r"iffi ili.*; H;fi

rnd other
counting ;'ilr*" i"i's
*,., q':y1, :1"1î:.Y::?.:::::*:Y: ;ff f
urchases.
:
ffi,}#,fi;ilfi ;;ffiffi; ;.;;;;. H;oi "a*"'

can atso be calcurated bv assuming "normali'
prici-earnings oi market-to-book ratios at the horizon date'

best for mature firms that pay regular cash
The dividend discount models derived in this chapter work
diyidends. The models also work when companie-s pay
tq calh by share.repurchases as well as. dividends' That
common said, it is also true that th; d;;;.rJ air.orrri *oa.i it
difficuit to use if the comPany pays no dividends at all or
In that case' it is easier to get Price
investors ifthe split ofpayout between cash dividends and repurchases is,unpredictable'
then dividing by the current number of
per share by foreeasting *J',rJoiog the company's total free cash flLw
and
vidends. shares outstanding.
ianwith
ns. Our BASIC
l. True/false True or false?
rate of return'
a. All stocks in an equivalent-risk class are priced to offer the same exPected
ed, and b. The value of a share equals the PV of future dividends per share'' .
hat the 2. Dividend discount modc! Regpo4dbriefly to the folowiltS s11tS11nj:

.you future dividends? That's crazy! A11 the investprs I
say stock price equals the present value of $ow
cted to are looking for caPital gains."
Dividend discount model Company X is expected to pay an end-of-year dividend of t5 a share. After
the dividend its stock is expected to sell at <110. If the market capitalization rate is 8%, what is the
current stock price?
Dividend discount model Company Y does not plow back any earnings and is expected to produce a level
dividend stream of t5 a share. If the current stock price is t40, what is the market capitalization rate?
Dividend discount model Company Z's earnings and dividends per share are expected to grow
indefinitely by 5% a year. If next yeart dividend is $10 and the market capitalization rate is 8%'
what is the current stock Price?
Dividend discount niodel Company Z-prime is like Z in all respects save one: Its growth will stop after
year 4.In year 5 and afterward, it will pay out all earnings as dividends. What is Z-prime's stock price?
Assume next year's EPS is $15.
Dividend discount model If company Z (see Problem 5) were to distribute all its earnings, it could
maintain a level dividend stream of $15 a share. Horar much is the market actually paying per share for
growth opportunities?
Dividend discount model Consider three investors:
a. Mr. Single invests for one year.
b. Ms. Double invests for two years.
c. Mrs. Triple invests for three years.
Assume each invests in company Z (see Problem 5). Show that each exPects to earn a rate of return of 8%
Per year.
9. True/false True or false? ExPlain.
a. The value of a share equals the discounted stream of future earnings per share'
b. The value of a share equals the PV of earnings per share assuming the firm does not grow, plus the
NPV of future growth opportunities.
Free cash flow Under what conditions does r a stock's market capitalization rate, equal its earnings-price
ratio EPSl/Pe?
*free
11. Free cash flow What do financial managers mean by cash flow"? How is free cash flow calculated?
Briefly explain.
t2. Horizon value What is meant by the "horizon value" of a business? How can it be estimated?
13. Horizon value Suppose the horizon date is set at a time when the firm will run out of
positive-NPV investment opportunities. How would you calculate the horizon value?
(Hint:Whatis the P/EPS ratio when PVGO : 0?)
Stock quotes and ratios Go to Business Standard at www.business-standard.com/stockPage and get

trading quotes for Bharti Airtel.
a. What is the latest Bharti Airtel stock price and market cap?
b. What is Bharti Airtel's dividend Payment and dividend yield?
c. What is Bharti Airtel's trailing P/E ratio?
d. Calculate Bharti Airtel's forward P/E ratio using the EPS forecasted by analysts for the next year.
e. What is Bharti Airtel's price-book (P/B) ratio?
are. After. stock guotes and

p/E ratios Look up Intel- (INTC), Dell Computer (DELL), oracle (oRCL), and
t9 lowlsf What are tl1e
rat is the Hewlett Packard Cfpql. n"nt the companies forward P/E ratios from highest
companies appears to have the most valuable
;rrffi ;;; ro.1ni ain"rent ratiosi which of these
lce a i-*m opportunities
vrro*ioo uy comparables- Look up PIE and

rte?
,il llB.ratl:t I",', 1t:-'1:':*T:::T::i.T::fI:"i$'""#":J
potential comparables: Sun TV Network,
to grow "'.. ;ffi;#ilffi;"r*r"i. same ratios for thefollowing
t"lli::I*I :;:i'::i:::::":
e is 8%; *i Media and NDrv. !e1 out the ratios i" lh. :1T.
ffi;;;;;TV entertainment price'
for these companies tightly grouped or scattered? If you did not know Zee's stock
top aftei would the comparables give a good estimate?

:k price?: 17. P/Eratios and the dividend
discount model Look up r"t" St*l'S1Il,-]'* tt::'":1l,lt",t*
t,-:.7^-)
and dividend
;.;* are the current and P/B ratios for these food compafiies?What are the'tlividend
p/E
,i
it could yield for each comPanY?
over the last five years? What EPS
hare for b, What are the growth rates of EPS and dividends for each comPany
:l ;ffi|f'#, r"r.."rr.d by analysts? Do these growth rates appear to be on a steady'trend that
could
"?.
be projected for the long run?
measure these companies' costs
c. would you be confident in applying the constant-growth DCF model to
of equitY? WhY or whY not?
three stocks:
18. Dividend discount model Consider the following
r of8% a. Stock A is expected to provide a dividend of {10 a share forever'
growth is expected to be 4o/o a
b. Stock B is expected to Pay a dividend of t5 next year. Thereafter, dividend
year forever.
Stock C is expected to pay a dividend of { 5 next year. Thereafter,
dividend growth is expected to be 20o/o
c.
a year for five years (i.e., until year 6) and zero
thereafter'
the market capitalization rate for each stock is 10%, which stock
is the most valuable? What if the
If
capitalization tate is 7o/o?
-price
,F model pharmecology is about to pay a dividend of $1.35 per share. It's a mature com-
'" ;"tffi;'-ff#Tr":nd dividends are expecied to grow with inflation, wiich is firecasted
at 2-75o/o per tear.
lated? a.WhatisPharmeco1ogy-qcur!€ntstockpric9?Thenomina1costofcapitalis9"5o/o..
b.Redopart(a)usingforecastedrealdividendsandarealdiscountrate.
(ROX) is 147o' It pays out one-half of earn-
20. Ttvo-stage DCF model' Compqny Q's current return on equity
.u). Corr.rrt book value'per share is $50. Book value per share
r"ti"l will
Iof ings as cash dividenil- O"y.J
rlue? grow as Q reinvests earnings.
Assurne that'the ROE and Payout ratio stay constant for the
next four years' After that'
competition forces ROE down to 11'57o and the payout ratio increases
to 0'8' The cost of capital
, get
is 11.5%.
grow in years 2, 3, 4, 5, and
a. What are Q's EPS and dividends next year? How will EPS and dividends
subsequent Years?
ratio and growth rate after
b. What is stockworth per share? How does that value depend on the payout
Q's
year 4?.
shareholders' required rate of

21. Earnings and dividends Each of the following formulas for determining
return can be right or wrong depending on the circumstances:
:r:
'+
.ie
: 3
----
1O4 Principles of Corporate Finance
DIV,
a.r:f+s
.b. 7 EPS,
= -----::
Po
For each formula construct a simple numerical example showing that the formula can give wrong answers
and explain why the error occurs. Then construct another simpli numerical example foiwhich thi formula
gives the right answer.
22. PVGO Alpha Corpb earnings and dividends are growing at L5% per yeal. Beta Corp's earnings and
dividends are growing at 8% per year. The companies' assets, earnings, and dividends p.. rh".. are now (at
date 0) exactly the same. Yet PVGO accounts for a greater fraction of n.tu Corp's stoik price. How is this
possible? (Hint:Therc is more than one possible explanation.)
23. DCF model and PVGO Look again at the financial forecasts for Growth-Tech given in Table 4.4. This time
assume you krorv that the opportunity cost of capital is r=.12 (discard the .099 fgure calculatedin the text).
Assume you do nof know Growth-Tech's stock value. Otherwise follow the assumptions given in the text.
a. Calculate the value of Growth-Tech stock.
b. What part of that value reflects the discounted value of P3, the price forecasted for year 3?
c. What part of P3 reflects the present value of growth opportunities (PVGO) after year 3?
d. Suppose that competition will catch up with Growth-Tech by year 4, so that it can earn only its cost of
capital on any investments made inyear 4 or subsequently. What is Growth-Tech stock worthnow under
this assumption? (Make additional assumptions if necessary.)
DCF and free cash flow Compost Science, Inc. (CSI), is in the business of converting Boston's sewage sludge
into fertilizer. The business is not in itself very profitable. However, to induce CSI to remain in business, tfie
Metropolitan District Commission (MDC) has agreed to pay whatever amount is necessary to yield CSI a 10%
book return on equity. At the end ofthe year CSI is expected to pay a $4 dividend. It has been reinvesting 40% of
earnings and growing at 4% a year.
a. Suppose CSI continues on this growth trend. What is the expected long-run rate of return from
purchasing the stock at $100? What part of the $100 price is attributable to the present value of growth
opportunities?
b. Now the MDC announces a plan for CSI to treat Cambridge sewage. CSI's plant will, therefore, be
expanded gradually over five years. This means that CSI will have to riinvest 80% of its earnings for five
years. Starting in year 6, however, it will again be able to pay out 50% of earnings. What will
be CSI's stock
price once this announcement is made and its consequences for cSI are known?
DCF and free cash flow Permian Partners (PP) produces from aging oil fields in west Texas. production
is 1.8 million barrels Per year in 2013, but production is declining it7% per yru for the foreseeable future.
Costs ofproduction, transPortation, and administration add up to $25 pir barrel. The average oil price
was
$65 per barrelin 2013.
PP has 7 million shares outstanding. The cost of capital is 9%. All of PPt net income is distributed as
dividends. For simplicity assume that the company will stay in business forever and that costs per barrel are
constant at $25. Also, ignore taxes.
a. What is the PV of a PP share? Assume that oil prices are expected to fall to $60 per barrel in2AL4,$55 per
barrel in 2015, and $50 per barrel in 2016. After 2016, assume a long-term trend ofoil-price increases at
5o/o per year.
b. what is PPt EPS/P ratio and why is it not equal to the 9%o cost of capital?
?iitil,free'trish flow nstructanewversionofTable4.T,assumingthatcompetitiondrivesdown

construct,
" "t* '.t^1::_:]_., "^ 1r trol^ ir ,,^^. A .tlo/în veAr 7. lf..So/oin
ar 7' vear g.
5'/' in vear 8'
1'F*ffiili'i,i;r':i*i::*'.::::*;,i:L:l:i:::il1,:tfnT"[:l*i"Y,.i
i],t)r, ."a later
" '0
years. what is the value of the concatenator business?
f],jt:il "rr -.:-- | ,*2.^)'^ ^^*1,^+ -.- i" Tlca ?'7\ crorr
;*.,:;;;:;;;1".*on.* &riancerndul'l::':y:::.T::i:.,_:11:.,]j"'.1,.1f".[f#ff'ffrtlll,,1:;
J answers
: formula
(RoE 17'87o) and reinvested about

ings and 5]..-:,i.'irar..l'oor,.t.,
t,' ::::...;;..t^n.qar nrs generally earned about 17.8olo on book equity =
:.:. :,.'" i:,.}i.1it,ffitilings.
^roarninoq The remaining
remainins.66.7o/ohas
66.70/ohas gone to fr"e .arh
free.urh flo*
flow to equity' Suppose' the company
now (at
:
w is this '..-,,;-...);*;,,1j{i"H[il:',Xkffi;ffi;?J#;;;;;;,i; *n
long run' what
:,..,..:..,-.::...,.:.,:...;î-+oi.e the same ROE and reinvestment rate for the io,,g
What is the implication
imprication for the growth
ror
paft (a) of
- - aL- ^^^+ of (L^,rl; ,rnrr
you rpvise vour
your answer tO part
to Of
free cash flow? For the cost ^t equityisrroula
^^,.i+.,? revise
and
=',...1."''IilTi::ill"r,
this question?
his time i^- but Free cash flow has
rprnverins. Frer
ic recovering'
I.rr+ is
he text). ..',.:2*:'.*,dluing free cashflow lUieilxjiy; ?1t:::*:.lte recent recession
r text. '.", gi";;i.pidly. Forecasts made in 2016 are as follows'
cost sf
: under
growth in free cash flow'
phoenix's recovery wili be complete by 202l,and there will be no further
sludge assuming a cost of equity of 97o'
a. calculate the PV of free cash flow,
ss, thg
outstanding. What is the price per share?
aL0% b. Assume that Phoenix has 12 million shares
do you expect that P/E ratio to change from20t7
to202|?
c. wt,ut i. Phoenix,s P/E ratio? How
.
t0% of
\n each of the years from 2017 to
ct. Confirm that the expected
rate of return on Phoenix stock is exactly 9o/o
from 2021.
'owth
CHALLENGE
e, be
29. Constant-growth DCF formula The constant-growth DCF formula:
r five DIVI
itock Pn:
" r-g
-
tion is sometimes written aS: ROE(1 - b) BVPS
:ure. Po
r-' bROE '' i '':'
earnings
was the plowbick ratio, and ROE is the ratis 'of
where BVPS is book equity value per share' b is
price'to-book ratio varies as ROE changes'
las per share to BVPS. Uie this equation to show how the
What ls price-to-book when ROE
: ri
are
.r ',- managers are
30. DCF valuation Portfolio
i..
-^-^-^-- ^*- frequently paid a proporti<
rn of the funds under management'
,n \ -r c6r n:-,:,r--,-lo
illl,lf iffi"i"Jl"ii;' *i,i;";";';;:;;;"il:"-*:l'::i::l1':'*j'ililllliil"?il3;:i:
Per
tat ::'.'rT:t1l"T:ilT;;;.*ii;;,il"i1."."""11i:l'"1i:Y:l:'f"1".'.:Ti':::i::T'f*:i:
Hffi.'rifi
.5"/o ;i;;ff;;tit".''ad'*ol'i':L:':::i:::'-1"J":iL:3;'S::T#ilif;
ffi im(
or Portrorro varue
vn[ue of the management contractl How would
tle
P:', ,^, ,-, 1a)
is esent
the:
the portfolio frorn nowlo
"161srt/, Yhat
*"i.*i""f". changeifyou invesied in stocks with a4o/oyrel&
I 06 . Principle-s o{ Gorpq1qlq.Enanse
;::1,: ReebY I
i:ri ren y.eaqq agq,.i!|4$p=*,gd€€.a,s iF silling high-quatltr+orts equipmenti

1i.,,:' Since those ea.lia"tr ;b, St.iff,ffi6ffi;ii&di&;"46;;n consistintiy profitable, Tle-iompany has issued
:;:.,:' 2 million shares, all oiwhich Cie,o*nqa_pfCeorge Reeby and his fiv6 children. . ,'
.;:;,,;x-::;': For some,riionthi'George has been wondering whether the time has come to'take'the compauy public. This'
5:i would allowhim to cash in on part of hiq i-nveslmer_t and.would rnake it easierforllhe'firmio r{se capital should
::;:;,:',., it wish toexpand in the future.
':-:.,::.:t: : : :
i.:,'.t . Buthow rnuch are'tht sliares worth?Georget fitstj4sliira is to loqk-at the firm's balance sheet, w-hlch shows ,:
.r1it thatthebookvalueoftheequityis$26.34rrtillioni.r$l1.1Zpur.share-,Aqhaiepriceof$13,17worl!{iutthestock,
,.l:..1: tfr"i tfr. Uootvalue ofthe equity is $ZO.a+mithp+;or-$13,17pershare,A shai:eprice of $13,17 would putthe stock: i
E.,,. G'gorge su9p.99it1thAt bqg\.value. is loJ negessari[ f goo4 guide 1o,a,9h,4r9ls. ma1!9t vqlue. He.thitlq of his '
daughtel lenni,.,wliq works ia
', who *crli$ irrvestment bank. She would undoubteclly
in an inveStment mow wlat
unaouUtealy know shares are worth. HC
what the bhares He ::
tophorGrhe-r:afteishe{inishes'wbrk that:evenirig at 9 otloak
decidestophorGrhe-r:afteishe{inishes'wbrkthat:evenirig
decides otloakor before she'startSthe nextde, et6.00 a.mi r':
Before phoning, Ge6ige'lois down some basic'data on the company's profitability. After recovering:from its, .,,
earlylosses; the companyhas earndd arreturn.that is higher thanits estimatEd 107o'cost of capital. Georgeis fairly
confident'thai thC ceii-npany could continue to grow fairly steadily for the next six to eight years.'In fact he feels- -
that:the compaRy'i,grovrthhasbeen somewial hqldbagklin the,last'fg1y,yeargb,yt-he demiindq.from'twgof the;
children for the company to make large dividend payments. Perhaps, if the company went public, it could hold
backondividendsandplowmoremoneybackin1othe-usiness...'
'Irhere are some-clouds on the hsrizon. Competitlon'is increasing and only that morning Molly Sports'.
announced plans to form a mail-order division. George is worried that beyond the next six or so years it might
Geolge realizes !ha! lgnnywillneed to knowmuch mole about,the prospgcts for the business,be(ore she can
put a final figure.on thq valqeof Reeby,Sports,'but he hopes that the infor,mation iq sufficient:for'her.to give a :
preliminary indication of the value of the shares.
Earnings per share,$, -,0.7.0,

.: 0,23.,: ..Q.8.1, .'1.10
..
1.52 't.64,. 2.00 ,. r2.03.
Dividend, $ " ,':0;(X) :0:00 : ,0.20 .0.20 0.30 0.60 0.60 0.80
Book value per share, $ 7,70 7.00 '7;61 ::8.51' 10.73 fi.n 13.17 14.40
-11.6
ROE, % -7.1 3.0 145 16.0 15.3 17.0 15.4
The Value of Common'Stocks.,. i07
tor divis
l4rs.
Help Ienny to forecast dividend payments for Reeby Sports and to estimate the value of the stock. You do not
io?
need to provide a single figure. For example, you may wish to calculate two figures, one on.fhs-6sumption
,vill have to that the opportunity for further profitable investment disappears after six years and anothlx a:$suming it
'
disappears after eight years.
'valuation?
..r-lr"''
led shares.
How much of your estimate of the value of Reeby's stock comes from the present value of growth
shares are
's the value
opportunities?
-
I
, ;1.r":4i:€
hirprice?) 1.
laq (www. '...a'U
,; -r:.-11-,1..:i'
-
ilpment.
rs issued
lic. This
t should
r shows
,e stock
of his
th. He
0 a.m.
rm its
fairly
: feels
rf the
hold
)orts
dght
can
yea

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Parl l Value

EE How courvroru srocxs Rne rRRoeo

shares, as well as individuals who own a handful of shares. tf you owned

Trading Results for lnfosys I

r that they 1S.{1 E* 13.95 ,

may not be a good guide to what those assets

Hindustan Unilever 36.4 Consumer 57.56

rn often ACC 16.86 3.07 Ultratech Cement 19.17

9 times Asian Paints 41.83 14.53 Berger Paints 38:24 7.61

or from. our orpanded formula

price alw,ayS:e(iialsltl00. r': r''

2. Capiklization rate is 15%.

88 Principles of Corporate Finance

do not invalidate the dividend discount model.8 com

ffi estnaanrue rHr cosr or eQurv clpltRl- and

1.76 3.2 I n.o 8.8 Po ='

43.20 .1.63 3.8 I

, s of Northwest! cost cif equity seem reasonab-le,

future growth is best an

Dangers Lurk in Constant-Growth Formulas t

.#lrliil'JffI',.'ffi:',#;f:tF;;;*Gi"*r, nir rirmura assumds it

assurnption leads to aii overestimate of

Book equity 10.00 12.00 14.40 15,55

Return on equity, ROE .25 .25 .16 .16

:wth GroMh rate of dividends (%) 20 92 I

THE LINK eerryEEN STOCK PRICE AND

The price equals

Po: IIS' + PVG.

:96 , Prinaiples,of Corpordte Finahce

Share priee :'pres'enivalue oflevel Stfeam of earnings

i:: ', '

nent Estimating Horizon Value

Horizon value (discouted back to pV d"t" o;

other words, we can calculate horizon valire 1

free Cailr-flow, Oivloends, and Repurcfti*i"

ts PVGO ffi. DIV,

;;;.', tu'*{.":".1'-'\:::: ::::,::':TtiT,:?::t*:*1i'i1-i:fi"fl?,ffitT

r"iffi ili.*; H;fi

ffi,}#,fi;ilfi ;;ffiffi; ;.;;;;. H;oi "a*"'

prici-earnings oi market-to-book ratios at the horizon date'

hat the 2. Dividend discount modc! Regpo4dbriefly to the folowiltS s11tS11nj:

Stock quotes and ratios Go to Business Standard at www.business-standard.com/stockPage and get

are. After. stock guotes and

vrro*ioo uy comparables- Look up PIE and

top aftei would the comparables give a good estimate?

shareholders' required rate of

?iitil,free'trish flow nstructanewversionofTable4.T,assumingthatcompetitiondrivesdown

(RoE 17'87o) and reinvested about

r text. '.", gi";;i.pidly. Forecasts made in 2016 are as follows'

i:ri ren y.eaqq agq,.i!|4$p=*,gd€€.a,s iF silling high-quatltr+orts equipmenti

preliminary indication of the value of the shares.

Earnings per share,$, -,0.7.0,

laq (www. '...a'U

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.#lrliil'JffI',.'ffi:',#;f:tF;;;Gi"r, nir rirmura assumds it

;;;.', tu'{.":".1'-'\:::: ::::,::':TtiT,:?::t:*1i'i1-i:fi"fl?,ffitT